Pitfalls of the commodity mentality

Lardner, M. Thomas | Jul 01, 1995

Investing in commodities is a challenging business. Despite its many challenges, however, all commodities -- whether coffee, sugar or pork bellies -- are basically the same. The investment process might be multifaceted and complex, but as far as commodities are concerned, the asset vehicle itself is not.

In the real estate arena, the exact opposite is true. Real estate investing is a far cry from owning and trading commodities in that, with real estate, the asset itself is exceedingly complex.

To ensure the asset achieves its maximum return, real estate owners and managers must understand how to differentiate the property from others in the market, as well as how to allocate resources that will enhance the asset's value.

Such a fundamental difference between real estate and commodity investment might, at first, seem to be self-evident. Unfortunately, in the minds of many investors, it is not.

The business needs to be learned

Real estate as an industry must be better understood and appreciated for what it is: a complex business that requires acumen and skill to operate and which demands a thorough understanding of the intricacies of asset valuation to succeed.

Failure to understand real estate in all its complexities and potential has created a number of obstacles that have plagued the real estate industry for years. In the 1980s, the U.S. government passed tax legislation which virtually overnight bankrupted hundreds of real estate concerns throughout the country.

The consensus at the time was that real estate developers, investors and other practitioners were simply making too much money. Thus, the politically correct thing to do was effectively grind the industry to a halt.

Capital hard to find

And the U.S. government did not act alone. The little-known Basel Accord, quietly reached in the picture-perfect surroundings of Basel, Switzerland, penalized real estate as an asset class. The Basel Accord required loan officers to assign a demanding set of evaluation criteria to real estate, the result of which made it virtually impossible to secure capital for any kind of real property investment.

The real culprit behind the government and banking industry's onerous decision against real estate firms was an overall lack of understanding and appreciation of the business as a whole.

People not involved in real estate often fail to recognize how managing real estate differs from other kinds of asset management.

In the commodity and equity markets, investors are not typically involved in the day-to-day aspects of running businesses represented by underlying assets.

In commercial real estate, however, the opportunity to maximize a property's financial performance virtually mandates a hands-on involvement on the part of the asset manager.

For example, managing a shopping center is like managing and operating a company. Not only do shopping center managers function as property managers, they must also act as leasing professionals, ac counting firms, security experts, collection agencies, advertising and public relations agencies, architects, construction supervisors, janitorial firms, retail training consultants and others.

Consider the magnitude required to manage a super regional shopping center such as Tysons Galleria. Located in northern Virginia, Tysons Galleria is a 1.9 million sq. ft. enclosed mall with 230 tenants that serve the greater Washington, D.C., market.

In 1994, Tysons Galleria generated annual sales of nearly $575 million and, including tenant rosters, employed nearly 7,100 people. That level of revenue would practically have qualified Tysons as a Fortune 500 company last year. A portfolio of several assets generating revenues of this proportion is clearly tantamount to managing the affairs of a corporate conglomerate.

Not just a simple investment

The conclusion is obvious: shopping centers, like other kinds of real estate, are not commodities. They require a broad and complex array of skills and services to ensure the maximum return on investment is achieved.

Plan sponsors and portfolio managers who wish to derive the greatest possible benefit from their real estate assets must understand its uniqueness as an asset class, and real estate advisers must strive to build awareness and appreciation for the complexity involved in real estate investing.

Like real property itself, real estate advisers and the services they provide are not commodities. And the differences among them can, and do, make a major difference in an asset's total return.